Relevant Costs for Decision Making

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Relevant Costs for Decision Making
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Cost Concepts for Decision Making

• A relevant cost is a cost that differs between
  alternatives.

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Identifying Relevant Costs

• Costs that can be eliminated (in whole or in
  part) by choosing one alternative over another
  are avoidable costs. Avoidable costs are relevant
  costs.
• Unavoidable costs are never relevant and include
• Sunk costs.
• Future costs that do not differ between the
  alternatives.

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Identifying Relevant Costs

• Sunk cost -- a cost that has already been
  incurred and that cannot be avoided regardless of
  what a manager decides to do.

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Identifying Relevant Costs
Well, Ive assembled all the costs
associated with the alternatives we are
considering.
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Identifying Relevant Costs
Great! The first thing we need to do is
eliminate all the sunk costs.
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Identifying Relevant Costs
Now that we have eliminated the sunk costs, we
need to eliminatethe future costs that dont
differbetween alternatives.
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Identifying Relevant Costs
The decision will be easier now. All we have
left are the avoidable costs.
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Sunk Costs are not Relevant Costs
Lets look at the White Company example.
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Sunk Costs are not Relevant Costs

• A manager at White Co. wants to replace an old
  machine with a new, more efficient machine.

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Sunk Costs are not Relevant Costs

• Whites sales are 200,000 per year.
• Fixed expenses, other than depreciation, are
  70,000 per year.
• Should the manager purchase the new machine?

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Incorrect Analysis

• The manager recommends that the company not
  purchase the new machine since disposal of the
  old machine would result in a loss

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Correct Analysis

• Look at the comparative cost and revenue for the
  next five years.

200,000 per year 5 years
100,000 per year 5 years
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Correct Analysis

• Look at the comparative cost and revenue for the
  next five years.

70,000 per year 5 years
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Correct Analysis

• Look at the comparative cost and revenue for the
  next five years.

The remaining book value of the old machine.
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Correct Analysis

• Look at the comparative cost and revenue for the
  next five years.

80,000 per year 5 years
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Correct Analysis

• Look at the comparative cost and revenue for the
  next five years.

The total cost will be depreciatedover the five
year period.
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Correct Analysis

• Look at the comparative cost and revenue for the
  next five years.

The remaining book value of the old machine is a
sunk cost and is not relevant to the decision.
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Correct Analysis

• Look at the comparative cost and revenue for the
  next five years.

Would you recommend purchasing the new machine
even though we will show a 45,000 loss on the
old machine?
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Correct Analysis
Lets look at a more efficient way to
analyze this decision.
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Correct Analysis
100,000 - 80,000 20,000 variable cost savings
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Correct Analysis
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Adding/Dropping Segments

• One of the most important decisions managers make
  is whether to add or drop a business segment such
  as a product or a store.
• Lets see how relevant costs should be used in
  this decision.

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Adding/Dropping Segments

• Due to the declining popularity of digital
  watches, Lovell Companys digital watch line has
  not reported a profit for several years. An
  income statement for last year is shown on the
  next screen.

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Adding/Dropping Segments
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Adding/Dropping Segments
If the digital watch line is dropped, the fixed
general factory overhead and general
administrative expenses will be allocated to
other product lines because they are not
avoidable.
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Adding/Dropping Segments
The equipment used to manufacture digital watches
has no resale value or alternative use.
Should Lovell retain or drop the digital watch
segment?
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A Contribution Margin Approach

• DECISION RULE
• Lovell should drop the digital watch segment only
  if its fixed cost savings exceed lost
  contribution margin.
• Lets look at this solution.

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A Contribution Margin Approach
Remember, depreciation on equipment with no
resale value is not relevant to the decision
since it is a sunk cost and is not avoidable.
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Comparative Income Approach

• The Lovell solution can also be obtained by
  preparing comparative income statements showing
  results with and without the digital watch
  segment.
• Lets look at this second approach.

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Beware of Allocated Fixed Costs
Why should we keep the digital watch segment when
its showing a loss?
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Beware of Allocated Fixed Costs
Part of the answer lies in the way we allocate
common fixed costs to our products.
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Beware of Allocated Fixed Costs
Our allocations can make a segment look less
profitable than it really is.
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The Make or Buy Decision

• A decision concerning whether an item should be
  produced internally or purchased from an outside
  supplier is called a make or buy decision.
• Lets look at the Essex Company example.

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The Make or Buy Decision

• Essex manufactures part 4A that is currently used
  in one of its products.
• The unit cost to make this part is

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The Make or Buy Decision

• The special equipment used to manufacture part 4A
  has no resale value.
• General factory overhead is allocated on the
  basis of direct labor hours.
• The 30 total unit cost is based on 20,000 parts
  produced each year.
• An outside supplier has offered to provide the
  20,000 parts at a cost of 25 per part.
• Should we accept the suppliers offer?

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The Make or Buy Decision
20,000 9 per unit 180,000
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The Make or Buy Decision
The special equipment has no resale value and is
a sunk cost.
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The Make or Buy Decision
Not avoidable and is irrelevant. If the product
is dropped, it will be reallocated to other
products.
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The Make or Buy Decision
Should we make or buy part 4A?
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The Make or Buy Decision

• DECISION RULE
• In deciding whether to accept the outside
  suppliers offer, Essex isolated the relevant
  costs of making the part by eliminating
• The sunk costs.
• The future costs that will not differ between
  making or buying the parts.

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The Matter of Opportunity Cost

• The economic benefits that are foregone as a
  result of pursuing some course of action.
  Opportunity costs are not actual dollar outlays
  and are not recorded in the accounts of an
  organization.

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Special Orders

• Jet, Inc. receives a one-time order that is not
  considered part of its normal ongoing business.
• Jet, Inc. makes a single product with a unit
  variable cost of 8. Normal selling price is 20
  per unit.
• A foreign distributor offers to purchase 3,000
  units for 10 per unit.
• Annual capacity is 10,000 units, and annual fixed
  costs total 48,000, but Jet, Inc. is currently
  producing and selling only 5,000 units.

Should Jet accept the offer?
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Special Orders
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Special Orders

• If Jet accepts the offer, net income will
  increase by 6,000.

We can reach the same results more quickly like
this Special order contribution margin 10
8 2 Change in income 2 3,000
units 6,000.
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Utilization of a Constrained Resource

• Firms often face the problem of deciding how to
  best utilize a constrained resource.
• Usually, fixed costs are not affected by this
  particular decision, so management can focus on
  maximizing total contribution margin.
• Lets look at the Ensign Company example.

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Utilization of a Constrained Resource

• Ensign Company produces two products and selected
  data is shown below

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Utilization of a Constrained Resource

• Machine A1 is the constrained resource. There is
  excess capacity on all other machines. Machine
  A1 is being used at 100 of its capacity, and has
  a capacity of 2,400 minutes per week.
• Should Ensign focus its efforts on Product 1 or 2?

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Utilization of a Constrained Resource

• Lets calculate the contribution margin per unit
  of the constrained resource, machine A1.

Product 2 should be emphasized. Provides more
valuable use of the constrained resource machine
A1, yielding a contribution margin of 30 per
minute as opposed to 24 for Product 1.
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Utilization of a Constrained Resource

• Lets calculate the contribution margin per unit
  of the scarce resource, machine A1.

If there are no other considerations, the best
plan would be to produce to meet current demand
for Product 2 and then use remaining capacity to
make Product 1.
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Utilization of a Constrained Resource

• Lets see how this plan would work.

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Utilization of a Constrained Resource

• Lets see how this plan would work.

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Utilization of a Constrained Resource

• Lets see how this plan would work.

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Utilization of a Constrained Resource

• According to the plan, we will produce 2,200
  units of Product 2 and 1,300 of Product 1. Our
  contribution margin looks like this.

The total contribution margin for Ensign is
64,200.
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Managing Constraints
Produce only what can be sold.
Finding ways to process more units through a
resource bottleneck
At the bottleneck itself Improve the
process Add overtime or another shift
Hire new workers or acquired more
machines Subcontract production
Eliminate waste.
Streamline production process.
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Joint Product Costs

• In some industries, a number of end products are
  produced from a single raw material input.
• Two or more products produced from a common input
  are called joint products.
• The point in the manufacturing process where each
  joint product can be recognized as a separate
  product is called the split-off point.

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Joint Products
Joint Costs
Oil
Common Production Process
Joint Input
Gasoline
Chemicals
Split-Off Point
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Joint Products
Joint Costs
Final Sale
Separate Processing
Oil
Common Production Process
Joint Input
Final Sale
Gasoline
Separate Processing
Final Sale
Chemicals
Separate Product Costs
Split-Off Point
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The Pitfalls of Allocation
Joint costs are really common costs incurred to
simultaneously produce a variety of end products.
Joint costs are often allocated to end products
on the basis of the relative sales value of each
product or on some other basis.
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Sell or Process Further

• It will always profitable to continue processing
  a joint product after the split-off point so long
  as the incremental revenue exceeds the
  incremental processing costs incurred after the
  split-off point.
• Lets look at the Sawmill, Inc. example.

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Sell or Process Further

• Sawmill, Inc. cuts logs from which unfinished
  lumber and sawdust are the immediate joint
  products.
• Unfinished lumber is sold as is or processed
  further into finished lumber.
• Sawdust can also be sold as is to gardening
  wholesalers or processed further into
  presto-logs.

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Sell or Process Further

• Data about Sawmills joint products includes

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Sell or Process Further
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Sell or Process Further
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Sell or Process Further
Should we process the lumber further and sell
the sawdust as is?
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End of Chapter 13